Regional President Speech

A Two-Headed Dragon for Monetary Policy James Bullard President and CEO Roundtable Discussion: Long-Run Economic Challenges: A Federal Reserve Perspective American Economic Association Meeting, NABE January 3, 2009 A Two Headed Dragon for Monetary Policy I will emphasize two medium-term issues for the Federal Reserve. (cid:131) Looking a few years ahead. (cid:131) I hope that qualifies as long-term challenges. I will not touch on regulatory reform in these opening remarks even though that is an important issue. (cid:131) A near-term challenge? Introduction Let me begin by recalling the Volcker Fed of 1979. (cid:131) 70s economy was characterized by dramat ically high interest rates and inflation by U.S. standards. (cid:131) Real economy also very volatile by later standards. (cid:131) The “monetarist experiment” of 1979-82 set up the Fed to “slay the inflation dragon.” An important moment in American Economic History. Set the stage for long booms punctuated by relatively mild recessions. Introduction Today’s situation is not 1979. (cid:131) Inflation is low, for instance. But the drama is similar. (cid:131) Aggressive actions have been taken by the Fed. One similarity: Dropping nominal interest rate targeting as the primary focus of monetary policy. (cid:131) That was the thrust of October 1979. (cid:131) This time, forced on the Fed by events and the zero bound on nominal interest rates. Main Concern My concern: How to keep medium- and longer-term inflation expectations anchored in this new reality (cid:131) Private sector completely accustomed to thinking in terms of nominal interest rate movements as the very definition of monetary policy. (cid:131) Normal times: Nominal interest rate targeting as espoused by Taylor and Woodford works well. (cid:131) Exceptional times like today: Ability to signal to the private sector via nominal interest rate movements is lost. (cid:131) Medium run expectations for inflation can begin to drift. The Two-Headed Dragon We Face The risk of a deflationary trap a la Japan. The risk of a 70s-style inflation stemming from a failure to control monetary base growth. The Risk of Deflation In this discussion, let’s not be too bothered by the facts: (cid:131) Core inflation measured from one year ago is about 2 percent. (cid:131) It would take a lot to drag a measure like this down to negative levels. (cid:131) So we are far from deflation today. (cid:131) But the spirit of the discussion is to focus on the medium term. If deflationary expectations become entrenched, then deflation could become a reality (cid:131) So this is a serious risk. The Risk of Deflation We also have the Japanese experience (cid:131) Clear problems in their banking sector in the 1990s, not unlike the U.S. today. (cid:131) Deflation in year-over-year core numbers for much of the time since the mid-1990s. Why worry about deflation? (cid:131) Nominal contracts, especially in housing. (cid:131) Unexpected deflation would worsen the situation. (cid:131) Also, Japan appears to be in a “steady state,” which I will now turn to. The Risk of Deflation I have been influenced by Benhabib, Schmitt-Grohé and Uribe on this issue: (cid:131) “The Perils of Taylor Rules.” Journal of Economic Theory. 2001 (cid:131) Also much subsequent work. The Risk of Deflation: Benhabib, Schmitt-Grohé and Uribe The idea in a nutshell: Any model with: 1. A Fisher relation R= r + πe 2. A continuous Taylor rule R = R(π) R´(π) > 1 which is “active.” 3. A zero bound on nominal interest rates. Will possess a second “trap” steady state. The Risk of Deflation: Benhabib, Schmitt-Grohé and Uribe The trap steady state is characterized by: (cid:131) Very low or zero nominal interest rates. (cid:131) Very low or negative inflation rates. The trap steady state co-exists with the target steady state. (cid:131) Inflation is at target or near target. (cid:131) Nominal interest rates are positive. The Risk of Deflation I like the two steady states idea as a way to conceptualize: (cid:131) The Bank of Japan policy rate has not been above 1% since 1994 –14 years! • And, it’s headed back down. (cid:131) This sounds more like a steady state outcome. • Not just a temporary visit. The risk is falling into the deflationary trap steady state: (cid:131) We do not know much about the dynamics. (cid:131) Just a way to think about possible outcomes. (cid:131) A long-run issue. The Risk of Deflation How to slay this part of the dragon? (cid:131) In the literature, “eliminate the bad equilibrium.” (cid:131) Adopt policies that change the set of long-run outcomes. • With that in mind … The paper was called “The Perils of Taylor Rules.” (cid:131) In the model, the policymaker is a slavish devotee of Taylor. (cid:131) The devotion works well at the target steady state. (cid:131) The rule is credible and is not abandoned at any point. (cid:131) But, this devotion creates the trap steady state. (cid:131) Logic: inflation is too low, but nominal interest rates cannot be lowered. (cid:131) This keeps the economy in the trap. The Risk of Deflation Volcker 1979 idea: Switch policy rules at a key juncture. (cid:131) This is so mething like what the FOMC did at the December meeting. (cid:131) De-emphasize nominal interest rates. (cid:131) Emphasis is on quantitative policy measures going forward. (cid:131) This emphasis should help to control expectations and guide inflation toward target. (cid:131) I am hopeful that the deflationary outcome can be avoided this way. Too much of a Good Thing? It’s possible. This leads to the second dragon head: (cid:131) Possibility of 70s style inflation as a medium term outcome. The Risk of Inflation Orthodox economics a la Milton Friedman: it is essential to think about money when thinking about policies to control inflation. (cid:131) The monetary base has increased dramatically in the U.S. since September 2008. (cid:131) Deficit spending is increasing dramatically. (cid:131) These would normally be considered inflationary developments –medium term. (cid:131) How to stop this? The Risk of Inflation: How to stop this? Two Ideas: (cid:131) Reversibility of liquidity programs. (cid:131) Set an inflation target. The Risk of Inflation: How to stop this? Times of Crisis and Lender of Last Resort. (cid:131) Central Banks often flood the system with reserves in times of crisis. (cid:131) Once the crisis passes, the action is reversed. (cid:131) The inflationary consequences of this type of action are minimal. The Risk of Inflation: How to stop this? Reversibility (cid:131) Many of the newly introduced programs are temporary. (cid:131) Some have explicit termination dates. (cid:131) Others are under 13(3) authority which has to end. “Emergency.” (cid:131) All involve collateralized lending. (cid:131) It seems the reverse build up could be reversed quickly and easily. The Risk of Inflation: How to stop this? Questions about Reversibility 1. Crisis is often a short event measured in “weeks.” (cid:131) This one is 13 months and promises to go on for a long time. (cid:131) A problem? No good news for 6 months? 2. What will the criteria be for exiting programs? (cid:131) Normal functioning of markets? 3. Scale of programs is very large. (cid:131) Large scale needed to have an impact. (cid:131) Might size hamper reversibility? The Risk of Inflation: How to stop this? The second idea, other than reversibility would be to set an explicit inflation target. (cid:131) Help focus expectations. (cid:131) Has to be backed by action. (cid:131) Would help fight the two-headed dragon. Conclusions A time of very fluid, volatile expectations. (cid:131) We know expectations are a major factor in macroeconomic performance. (cid:131) How the Fed acts in 2009 may have important consequences fro the longer run. I emphasized two risks. (cid:131) A Japanese-style deflation trap risk. (cid:131) Inflation risk as in the 1970s. (cid:131) Both very real medium-term risks. An explicit inflation target would help mitigate these risks. Long-Run Economic Challenges: A Federal Reserve Perspective James Bullard President and CEO American Economic Association Meeting, NABE January 3, 2009 A Two-Headed Dragon for Monetary Policy James Bullard President and CEO Roundtable Discussion: Long-Run Economic Challenges: A Federal Reserve Perspective American Economic Association Meeting, NABE January 3, 2009

James Bullard (2009, January 2). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090103_james_bullard

@misc{wtfs_regional_speeche_20090103_james_bullard,
  author = {James Bullard},
  title = {Regional President Speech},
  year = {2009},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20090103_james_bullard},
  note = {Retrieved via When the Fed Speaks corpus}
}